Risk on is the name of the investing game right now with the S&P 500 back above the 3000 level and the ten-year treasury yields sneaking back up over .7%. Bad economic reports and flare-ups political between the U.S. and China have quickly been shrugged off as “priced in” and every glimpse of promising results from vaccination studies are aggressively bought. Although a Bloomberg survey of current business conditions is literally the worst ever, a similar survey of expectations of better business ahead is at the highest level ever. Of course, everyone is acknowledging that the backstop the FED has provided is the de facto driving force for asset markets. The FED has been on a buying binge (they have even bought junk bond ETFs) to support markets and their balance sheet has rocketed over $7 trillion ($7.037 trillion as of last Wednesday.)
Stock markets worldwide, in fact have picked up considerably as other central banks are following suit – flooding the markets with “liquidity” as the fundamentals of the world economy take the biggest hit in history. Foreign governments are also following suit with free-money handouts/bailouts just as in the U.S. As an example, the Bundesbank in Germany just authored a $10 Billion bailout of Lufthansa. There is quite an obvious disconnect between stock prices and current economic reality. Time will tell whether the gap is corrected by an economic resurgence or by lower asset valuations. However, there is still a tremendous amount of economic damage to contend with over the months to come. For the second quarter, GDP estimates in the -30.5% (NY Fed) to -41.9% (Atlanta Fed) tracking range. Whether the realized contraction of the U.S. economy is simply dismissed as priced-in or if it shocks risk assets off their upward trajectory will largely be a function of investors’ interpretation of the Fed’s reaction-function to additional weakness as the post-pandemic landscape comes into focus. Right now, investors are depending on the Federal Reserve not having come close to exhausting its toolbox. What specifically the FED will focus on is speculative and timing is questionable, but the FOMC has a strong incentive to keep something in reserve once V-shape recovery ambitions are fully abandoned.
The magnitude of this economic contraction is so extreme that there is not any historical context. The speed and power of the March contraction in asset prices has left us looking for a benchmark for valuation as the majority of corporations are not guiding going forward and the concept of Price-to-Earnings ratios, for example, are completely ambiguous. The rebound in markets will undoubtedly overextend and although we don’ t know where that over-extension is price or time-wise, we are sure to see some risk priced back in to the market as the economic switch isn’t magically turned back on in June.
Regards and good investing,